Neil Barofsky hates the Treasury Department. From what I understand, the feeling is more than mutual.

Barofsky is back today with an op-ed in the NYT, which is ironic, because one of Treasury's main criticisms is that he's a relentless grandstander. (He is.) In it, Barofsky claims:

Worse, Treasury apparently has chosen to ignore rather than support real efforts at reform, such as those advocated by Sheila Bair, the chairwoman of the Federal Deposit Insurance Corporation, to simplify or shrink the most complex financial institutions.

Well, Sheila Bair pointedly did NOT support the Brown-Kaufman amendment (which would have broken up the large banks), so we can assume he's not talking about that. But Bair has been talking about forcing the large banks to shrink or simplify themselves in order to comply with the "resolution plan" requirement in Dodd-Frank. Presumably, this is what Barofsky is talking about. As I've said before, I think resolution plans are an excellent idea, and will help considerably in successfully resolving large banks in the future.

Do you know how the "resolution plan" requirement got into Dodd-Frank in the first place? Because Treasury included it in its initial legislative proposal. And do you know why Treasury hasn't been going around talking about using the resolution plans to shrink or simplify the large banks? Because Dodd-Frank gives the authority to require and implement resolution plans to the Fed and the FDIC, not the Treasury. Since Barofsky is clearly new at this, he may not know that agencies typically don't go around talking about what it thinks another agency should do in its rulemakings, especially before the other agency has even issued its proposed rules.

The only real question is: when is Barofsky going to start formally accepting campaign donations?

Here's an interesting exchange with an AIG executive from the FCIC interviews. As I explained a while ago, what really killed AIG were the terms of its CDS contracts on subprime CDOs and RMBS — specifically, the contracts included Credit Support Annexes (CSAs) which required AIG to post collateral based on the mark-to-market value of the underlying CDOs. When the CDO shut down in 2007, mark-to-market prices collapsed as well, forcing AIG to post tens of billions in collateral on their CDS contracts.

In the FCIC's interview with Andrew Forster (mp3), who headed AIGFP's London branch, the interviewers — to their credit — actually directly asked asked Forster about this. His response is fascinating. The two FCIC interviewers were Chris Seefer and Dixie Noonan, and I've transcribed the exchange to the best of my ability, since it's pretty short: (emphasis mine)

Chris Seefer (FCIC): Did you know that the contracts for the multisector [CDS] book included terms that would require AIGFP to post collateral if there was a decline in the market value of the reference collateral?

Andrew Forster (AIG): Um, as I've looked back over my emails and notes, it's clear that there were times that I was copied on an email that would have that sort of information. Did I recall that? Did I look at it? No, I didn't. But it would be disingenuous for me to say that I clearly had no knowledge of it, because I must've, I should've had some back at that time. But it wouldn't really have rang any great — it wouldn't have resonated with me on the basis that my understanding was pretty much every derivative product that you write is gonna come with a CSA and a collateral agreement. That's just the market standard. So it wouldn't be odd if that was the case. But the exact specific terms of the different ones, no, I didn't really focus on it at the time.

...

Dixie Noonan (FCIC): You said that it was typical for the contracts to have collateral provisions. Was it typical, based on your understanding at the time, for the collateral provisions to be based on declines in the market value of the underlying securities?

Andrew Forster (AIG): Yeah I mean a typical derivative, or any credit derivative, they would all come — my understanding is that the market standard would be that that came with a CSA agreement and a collateral agreement, and that would be based on some estimate of market value for those products.

Dixie Noonan (FCIC): And would that be true not just for asset-backed security CDOs, but also for corporate CDS?

Andrew Forster (AIG): Yeah, I mean we wrote lots of other single-name corporate CDS. If you write one of those, it all comes with a collateral — I mean, 99% of the time it's gonna come with a collateral agreement. And it's based on the, you know, replacement value, or something like that, for the product.

OK, to be clear, it's simply not true that the "market standard" was for CDS on asset-backed securities to include full-blown CSAs, which require counterparties to post collateral based on mark-to-market prices. The only other big protection sellers for CDS on asset-backed securities at this time were the monoline insurers, which did not post collateral based on market prices. (The monolines did, however, agree to post collateral when their credit ratings were downgraded, but that's another story.) Whether protection sellers would have to post collateral based on market prices was a fairly contentious and prominent issue, and yet Forster was apparently unaware that a debate even existed. To him, CDS on asset-backed securities were just another derivative, and since most derivatives included full CSAs, CDS on asset-backed securities should naturally include CSAs too. (It sometimes took weeks to negotiate CSAs for bespoke derivatives, so I don't know why Forster thought all these deals should just include routine CSAs.)

Of course, there's a reason why the collateral-posting issue for CDS on asset-backed securities was so contentious: because a full CSA exposes the counterparties to significant market risk. So if you're a protection seller on a CDS, you would specifically want to avoid a full CSA when the underlying security trades in a particularly illiquid market, where prices jump around a lot, because that could require you to post large amounts of collateral on very short notice. AIG learned that the hard way.

That Forster gave this really very fundamental issue so little thought is just amazing.

In general, I'm not concerned about the GOP's efforts to roll back financial reform. House Republicans can pass all the bills they want; they're not going to get a vote in the Senate.

However, the one aspect of financial reform that I think could legitimately be rolled back is interchange (a.k.a., the Durbin amendment), which is unfortunate, because I still haven't heard a single legitimate argument against it. The problem is that the Durbin amendment has a ridiculously powerful coalition lined up against it — the community banks, credit unions, and, apparently, the teachers' unions. And yes, the big commercial banks too, although (a) it's the community banks who are driving the anti-Durbin movement, and who could put it over the top, and (b) the big banks' power in Congress is wildly, absurdly overrated anyway. As Barney Frank said recently regarding the fight over rolling back the Durbin amendment: "The lobbying power doesn't come from the big banks. The community banks beat the big banks." Of course, the opposition from JPMorgan/Wells Fargo/BofA is certainly still a factor — mostly what they can bring is a certain professionalization to the lobbying effort.

The community banks and credit unions are so powerful because they're in every member's district, they usually give to politicians' campaigns, and they tend to be very involved in local society. Those are the kinds of traits that command a Congressman's attention. And right now, the community banks, credit unions, and big commercial banks are screaming to their Congressmen and Senators about interchange. These kinds of measures need to gather a bit of momentum in Congress to have a chance, and I definitely get the sense that the momentum for rolling back the Durbin amendment is building.

On March 15, Sen. Jon Tester (D-MT) introduced the "Debit Interchange Fee Study Act of 2011," which delays the implementation of the interchange rules until July 21, 2012, expressly voids the Fed's proposed interchange rules, and directs the Fed, OCC, FDIC, and the National Credit Union Administration (NCUA) to conduct a study on a parade of horribles that might result from an interchange fee cap. It's a decidedly unsubtle message ("do NOT do through with this!"), and one that regulators aren't likely to ignore. For all intents and purposes, it would kill the Durbin amendment. Tester's amendment is also co-sponsored by 6 Democrats and 7 Republicans, giving it the all-important "bipartisan" label. (At the very least, it guarantees that the Washington Post editorial page will support the bill.)

On the other side of the fight, the main interest group supporting the Durbin amendment — namely, the merchants — is, I fear, too loosely organized, or simply not powerful enough, to win this kind of low-profile battle. A couple of merchant groups are already attacking Tester for his bill, but (a) it's too early in the electoral cycle for the attack ads to have much of an effect, and (b) Tester's in for a bitter re-election fight no matter what, so the fact that someone is running attack ads isn't likely to scare him.

The primary obstacle to rolling back the Durbin amendment is, I suppose not surprinsgly, Sen. Durbin himself. Durbin is the second-ranking member of the Senate, so he's got significant clout, especially among Democrats. Will Durbin be able to prevent Tester's bill from coming up for a vote until July 21, the date that Dodd-Frank requires the interchange rules to take effect? Maybe. He likely won't get any help in committee though, since the Chairman of the Senate Banking Committee is now Tim Johnson, who's from a very bank-friendly state (South Dakota), and is sometimes referred to as "the Senator from Citibank." Not surprisingly, Johnson voted against the Durbin amendment the first time around.

Durbin has promised that he'll make sure Tester's bill will need 60 votes to pass, and I think he'll be able probably be able to keep that promise. Whether Durbin can win that vote is another matter, because, again, he's battling a ridiculously powerful coalition in the community banks, credit unions, teachers' unions, and the big commercial banks. I've been tracking this issue pretty closely, and while my gut sense is that Durbin will be able to hold the line with wavering Democrats, I'm not particularly confident about that.

A report by BofA banking analyst Guy Moszkowski got a lot ofattentionyesterday, because Moszkowski claimed in the report that Goldman had a more aggressive interpretation of the Volcker Rule with regard to principal investing than the rest of the market. Specifically, Moszkowski said that:

“the market interpretation of Volcker rules is that [non-fund principal investing] will be off-limits ahead, but GS believes that many such investments will remain permissible, and will be closing on a ‘meaningful’ one in China shortly.”

I have no idea what Moszkowski is talking about. It’s absolutely not the “market interpretation” that the Volcker Rule will prohibit non-fund principal investing. Exactly the opposite. The Volcker Rule does not prohibit non-fund principal investing; it’s not even a close call. Nor, by the way, was it intended to. This was well understood during the financial reform debate.

So for all the analysts out there, I’ll walk you through it. The Volcker Rule, which is located in Section 619 of Dodd-Frank (pdf), contains the following prohibition:

(A) engage in proprietary trading; or
(B) acquire or retain any equity, partnership, or other ownership interest in or sponsor a hedge fund or a private equity fund.

Since Goldman was specifically talking about non-fund principal investing, (B) doesn’t apply. The only way that non-fund principal investing could be prohibited by the Volcker Rule, then, is if it’s considered “proprietary trading” under (A).

So now we have to go look at the definition of “proprietary trading,” which is located in § 619(h)(4):

(4) PROPRIETARY TRADING.—The term ‘proprietary trading’, when used with respect to a banking entity . . . , means engaging as a principal for the trading account of the banking entity . . . in any transaction to purchase or sell, or otherwise acquire or dispose of, any security, any derivative, any contract of sale of a commodity for future delivery, any option on any such security, derivative, or contract, or any other security or financial instrument that the appropriate Federal banking agencies, the Securities and Exchange Commission, and the Commodity Futures Trading Commission may, by rule as provided in subsection (b)(2), determine. [emphasis mine]

OK, so only transactions for the “trading account” are considered proprietary trading. Would non-fund principal investments be transactions for the trading account? Well, let’s look at the definition of “trading account,” which is found in § 619(h)(6):

(6) TRADING ACCOUNT.—The term ‘trading account’ means any account used for acquiring or taking positions in the securities and instruments described in paragraph (4) principally for the purpose of selling in the near term (or otherwise with the intent to resell in order to profit from short-term price movements), and any such other accounts as the appropriate Federal banking agencies, the Securities and Exchange Commission, and the Commodity Futures Trading Commission may, by rule as provided in subsection (b)(2), determine. [emphasis mine]

Principal investing is, by definition, medium- to long-term, which means that principal investments would NOT be transactions for the trading account. In fact, the trading account definition is virtually identical to the “trading book” definition in the accounting rules (which was intentional). And, not surprisingly, principal investments are not typically part of the trading book. (That’s why Goldman distinguishes between “trading” and “principal investments.”)

So in sum, non-fund principal investments are not prohibited by the Volcker Rule because they are by definition medium- to long-term, which means they are not transactions for the “trading account,” and thus not considered “proprietary trading” under the Volcker Rule.

Cate Long and FinanceObserver have asked me to do a post on Title VIII of Dodd-Frank, so here goes. Title VIII is something of a wildcard in financial reform. It establishes a regulatory and supervisory regime for what it calls “financial market utilities” (FMUs), which are basically entities that clear and settle payments, securities, or other financial transactions between financial institutions. This is the critical infrastructure of the financial system. However, Title VIII doesn’t apply to every single electronic payments system that fits the definition of an FMU; it only applies to “systemically important” FMUs.

Naturally, the Financial Stability Oversight Council (FSOC) determines which FMUs are systemically important. The Fed, however, is the one ultimately charged with developing and enforcing the prudential standards for systemically important FMUs. Title VIII also gives systemically important FMUs access to the discount window, which is a no-brainer — but which I’m sure the usual suspects, who like to appear to be “savvy commentators” by feigning outrage over everything, will object to nonetheless (bailouts!).

There are two main issues in Title VIII. First, which FMUs will be deemed “systemically important”? Second, what will the prudential standards for systemically important FMUs be?

Financial Market Utilities and “Systemic Importance”

In the context of FMUs, Title VIII defines “systemically important” and “systemic importance” as:

[A] situation where the failure of or a disruption to the functioning of a financial market utility ... could create, or increase, the risk of significant liquidity or credit problems spreading among financial institutions or markets and thereby threaten the stability of the financial system of the United States.

That’s obviously a very broad definition (as are the criteria Title VIII requires the FSOC to consider), so the reality is that the FSOC will have broad authority to designate pretty much any FMU it wants “systemically important.”

Based on the proposed rule they released last week, the FSOC seems inclined to limit the “systemically important” label to the major institutional and interbank players — CHIPS, the DTCC entities, etc. That means the FSOC will probably not designate retail payment systems as systemically important (save possibly for Visa), or at least not initially.

I hate how in discussions like these (and especially in comment letters), no one is willing to talk about specific entities — to name names, as it were. Everyone just talks in generalities about broad types of entities, even though we all know exactly which entities we’re debating. Screw that. If I had to guess, gun-to-my-head-style, I’d say the FSOC’s list of systemically important FMUs will be (or, more accurately, will include):

New York Portfolio Clearing (NYPC), which clears interest-rate futures and was just launched recently, will probably also get the “systemically important” designation once it gets going, since I understand it has the support of the dealers.

Yes, I do think that JPM and BNY (the two clearing banks) will be deemed systemically important FMUs. They clearly meet the definition of an FMU — they both operate a “multilateral system for the purpose of transferring, clearing, or settling” financial transactions — and they can’t squeeze their way into any of the § 803(6)(B) exclusions. And they’re both obviously systemically important: together, they clear over $1.6 trillion in tri-party repos. For a long time, the big fear didn’t involve one of the big investment banks like Lehman failing, it involved one of the two clearing banks failing (since that would affect all of the dealers that use the bank as their clearing bank).

Moreover, JPM’s margining practices with Lehman were almost comically inadequate. For example, for 3 months JPM allowed Lehman to post about $8bn worth of CDOs, valued at par, as margin. And when JPM later “discovered” that these CDOs were worth significantly less, they hit Lehman with a $5bn margin call. Essentially, JPM had been carrying $5bn of uncollateralized exposure to an obviously faltering investment bank in the Summer of 2008. Given JPM’s obvious systemic importance, there’s no way that kind of thing should be allowed to happen. And that’s why the two clearing banks need to be subject to minimum prudential standards specifically for their clearing functions.

What Will the Prudential Standards for FMUs Be?

What makes Title VIII such a wildcard is that it completely outsources the development of the actual prudential standards for FMUs to the regulators. Section 805(a)(1) says that the Fed “shall prescribe risk management standards, taking into consideration relevant international standards and existing prudential requirements, governing ... the operations related to the payment, clearing, and settlement activities of” systemically important FMUs.

So what will kind of prudential standards will the Fed impose? For that, I direct you to the BIS Committee on Payment and Settlement Systems’ recent report, “Principles for Financial Market Infrastructure.” It’s highly likely that this will be a blueprint for the prudential standards under Title VIII. Not only does Title VIII explicitly require the Fed to consider “international standards,” but the Chair of the Committee on Payment and Settlement Systems just so happens to be NY Fed president William Dudley. So the report most likely represents the current Fed thinking on FMUs.

I won’t even try to summarize the entire 153-page report, but I will pull the most important proposal for you:

“A payment system, [central securities depository], or [securities settlement system] ... should have sufficient liquid resources to effect, at a minimum, timely completion of daily settlement in the event of the inability of the [one/two] participant[s] and [its/their] affiliates with the largest aggregate payment obligation[s] to settle those obligations. A CCP should have sufficient liquid resources to meet required margin payments and effect the same-day close out or hedging of the [one/two] participant[s] and [its/their] affiliates with the largest potential liquidity need[s] in extreme but plausible market conditions.”

Clearly, national regulators differ on whether FMUs should be required to be able to withstand the failure of one or two of their biggest counterparties/members. Whether the Fed goes with a “one failure” or “two failures” test will be extremely important for FMUs like JPM/BNY and the clearinghouses, because a “two failures” test would require them to hold significantly higher capital and liquidity buffers. And since I’m making predictions in this post, I’m guessing the Fed will go with a “two failures” test.

In any event, Title VIII definitely bears watching. It’s one of the big remaining wildcards in financial reform.

About Me

I'm a finance lawyer in New York. I used to focus on derivatives and structured finance (you know, back when there was a structured finance market). I spent the majority of my career at one of the major investment banks. My background is in economics and, unfortunately, politics.

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